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Cyprus Salvaged After EU Deal Shuts Bank to Get $13B

Jeroen Dijsselbloem, the Netherlands's finance minister and president of the Eurogroup, center, speaks as Christine Lagarde, managing director of the International Monetary Fund, left, and Olli Rehn, economic and monetary affairs commissioner for the European Union, listen during a news conference following the Eurogroup meeting in Brussels on March 25, 2013. Photographer: Jock Fistick/Bloomberg

March 25 (Bloomberg) -- Cyprus dodged a disorderly
sovereign default and unprecedented exit from the euro by bowing
to demands from creditors to shrink its banking system in
exchange for 10 billion euros ($13 billion) of aid.

Cypriot President Nicos Anastasiades agreed to shut the
country’s second-largest bank under pressure from a German-led
bloc in an overnight negotiating melodrama that threatened to
rekindle the European debt crisis and rattle markets.

It was the second time in nine days that Cyprus struck a
deal with its euro partners and the International Monetary Fund,
capping a tumultuous week that underscored the contradictions of
euro-crisis management that has dominated European policy making
for more than three years. Cyprus, the euro area’s third-smallest economy, is the fifth country to tap international aid
since the crisis broke out in Greece in 2009.

The first Cypriot accord, reached March 16, fell apart
three days later when the parliament in Nicosia rejected a key
plank, a tax on all bank accounts that sparked the indignation
of smaller depositors. Efforts to win an alternative bailout
from Russia, which loaned Cyprus 2.5 billion euros in 2011 when
the nation was shut out of international markets, failed.

‘Playing Games’

“Nobody knows where we are heading,” said Epifanos
Epifaniou, 50, who used to drive a delivery truck in Nicosia and
has been unemployed for six months. “People are playing games
with Cyprus. We are alone. Nobody is supporting us.”

The euro retreated 0.4 percent, trading at $1.2935 at 2:33
p.m. in Frankfurt, after initially rising as much as 0.5
percent. Stocks gained, with the Stoxx Europe 600 Index rising
0.5 percent. Italian 10-year bonds erased their decline since
last month’s inconclusive election.

German Chancellor Angela Merkel lauded the agreement as
lawmakers in her coalition embraced the package, which should go
to a vote in Berlin in the coming weeks. The agreement goes a
“long way” toward satisfying Germany’s Bundestag, Christian
Democratic lawmaker Norbert Barthle said in an interview.

Bartering

The breakthrough came after Anastasiades bartered with
officials including EU President Herman Van Rompuy, European
Central Bank President Mario Draghi and IMF Managing Director
Christine Lagarde. It was then sealed by the finance ministers,
some of whom went out to dinner while the talks were ongoing.

With the ECB threatening to cut off emergency financing for
tottering banks as soon as today, Cyprus’s leaders engineered
another way of shrinking the island’s financial system.

The revised accord spares bank accounts below the insured
limit of 100,000 euros. It imposes losses that two EU officials
said would be no more than 40 percent on uninsured depositors at
Bank of Cyprus Plc, the largest bank, which will take over the
viable assets of Cyprus Popular Bank Pcl, the second biggest.

Cyprus Popular Bank, 84 percent owned by the government,
will be wound down. Those who will be largely wiped out include
uninsured depositors and bondholders, including senior
creditors. Senior bondholders will also contribute to the
recapitalization of Bank of Cyprus.

Debt Doubts

The squeezed banking industry will likely lead to a “sharp
drop” in Cyprus’s gross domestic product this year and next,
according to Reinhard Cluse, a London-based economist at UBS AG.
As a result, the euro group’s debt-to-GDP ratio target of 100
percent by 2020 “must be doubted,” he said.

The Cypriot Finance Ministry said in a January presentation
that bailing out the country may push debt to a peak of about
140 percent of GDP next year.

“Cyprus’s sovereign debt problems will remain an issue of
concern -- for European policy makers and for the markets,”
Cluse wrote in a note to clients today.

Banks in Cyprus, which have been shut for the past week,
will remain closed until further notice. Lawmakers in Cyprus
voted last week to impose capital controls to prevent a run on
deposits when they reopen.

The union representing Cypriot banking workers said today
the Mediterranean island is faced with a “painful compromise,”
according to a statement posted on its website. It urged
employees to be ready to return to work when banks reopen.

Better Solution

“This solution we reached tonight doesn’t have the
downsides that the solution of last week did,” said Dutch
Finance Minister Jeroen Dijsselbloem, chairman of the euro
ministers’ panel. He said the deal was beyond the range of
“political possibilities” a week ago.

The Cypriot parliament won’t have to vote again because it
has already passed laws on bank restructuring, officials said.
On the creditors’ side, legislatures in Germany, Finland and the
Netherlands may hold votes to approve loans to Cyprus from the
European Stability Mechanism, the 500 billion-euro rescue fund.

Klaus Regling, managing director of the rescue fund, said
approval by creditor governments in mid-April will pave the way
for the first payouts to Cyprus in early May.

Lagarde said she will recommend that the IMF provide loans,
without giving a figure. “There might have been a bit of
friction here and there,” she said of the talks.

Solvent Banks

The next step lies with the ECB, which needs to keep funds
flowing to solvent Cypriot banks to enable them to open. While
Draghi and Executive Board member Joerg Asmussen left Brussels
without commenting to reporters, a statement by the ministers
said the bank will channel liquidity to Bank of Cyprus “in line
with applicable rules.”

The seizure of larger deposits may spark tensions with
Russia, the source of an estimated $31 billion in holdings in
Cypriot banks according to Moody’s Investors Service. A Cypriot
mission to Moscow last week failed to yield an alternative to
the European-sponsored bailout.

Still, Russian President Vladimir Putin ordered his
government to discuss restructuring a 2011 loan to Cyprus,
Russian news service RIA Novosti cited a spokesman as saying.

The effort to go after insured deposits, while abandoned,
may have harmful repercussions, said Moody’s in a note early
today. “Policy makers’ recent decisions raise the risk of
deposit outflows, capital flight, increased bank and sovereign
funding costs and broader financial-market dislocation
throughout the euro area in the future,” Moody’s said.

Nine Months

In a replay of tensions over aid for Greece at the outset
of the crisis, European governments had wrangled over aid for
Cyprus for nine months, exposing holes in the revamped economic
management system that was built in three years of emergency
policymaking, often at all-night summits.

A tightening of Europe’s budget-deficit restrictions and
new rules to penalize countries with unbalanced economies or
asset bubbles failed to stop the rot in Cyprus, which makes up
less than 0.2 percent of euro-region output.

Hundreds of protesters massed outside the floodlit
presidential palace in Nicosia late yesterday, one group
brandishing a banner that said: “It’s capitalism, stupid.”